Suppose economists observe that an increase in government spending of $15 billion raises the total demand for goods and services by $60 billion. If these economists ignore the possibility of crowding out, they would estimate the marginal propensity to consume (MPC) to be .

a. 1/4
b. 3/4
c. 1/4
d. 4

Now suppose the economists allow for crowding out. Would their new estimate of the MPC be larger or smaller than their initial one?

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Priatouri Priatouri · Answer 1 · 2020-07-07T02:57:02+02:00

Answer:

Option B, 3/4 is correct answer.

Explanation:

Given an increase in government spending = $15 billion.

The increase in total demand for goods and services = $60 billion.

Firs calculate the expenditure multiplier by dividing the increase in demand for goods and services with an increase in government spending.

Expenditure multiplier = 60 / 15 = 4

Now find the MPC with the help of expenditure multiplier.

[tex]\text{ Expenditure mulitplier} = \frac{1}{1 - MPC} \\4 = \frac{1}{1 - MPC} \\4 – 4MPC = 1 \\MPC = \frac{3}{4}[/tex]

Thus, option B is correct.

Now solve for the second case, the allow for crowding out.

If there is crowding out that means multiplier will be higher than initial multiplier.

[tex]frac{1}{1 - MPC} > 4 \\1 > 4 – 4MPC \\MPC > \frac{3}{4}[/tex]

Thus, the new MPC will be greater than the previous one.